Category Archives: securities

SEC Laser-Focused on Conflicts Disclosures by Advisors and Broker-Dealers

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In two recent cases, the SEC ordered JP Morgan Chase to pay over $270 million for what it deemed inadequate disclosures about certain conflicts of interest. When closely examined, these two cases illustrate just how detailed and granular the Commission can be when evaluating and prosecuting conflicts non-disclosure issues.

The Proprietary Funds Case

On December 18, 2015, the SEC announced that two J.P. Morgan wealth management subsidiaries had admitted wrongdoing (though no intentional violations) relating to the firm’s investment advisory business and agreed to pay $267 million.[1] Specifically, J.P. Morgan Securities LLC (JPMS) and JPMorgan Chase Bank, N.A. (JPMCB), preferred to invest clients in the firm’s proprietary mutual funds without properly disclosing this preference to clients. In addition, JPMS breached its fiduciary duty to certain wealthy clients when it did not inform them that they were being invested in a more expensive class of J.P. Morgan mutual funds shares than other available classes, or that JPMS preferred third-party-managed hedge funds that made certain “retrocession” payments to a J.P. Morgan affiliate.

The level of scrutiny applied in this case is striking. The SEC was initially focused on a possible charge that JPMS was improperly steering clients to house products so that it and its affiliates could make additional fees. JPMS’s Form ADVs, however, disclosed that JPMS “may have a conflict of interest in including affiliated [Mutual] Funds…because [JPMS] and/or its affiliates will receive additional compensation.” Further, in advance of opening an account, JPMS clients were specifically informed how much of their assets were to be allocated between proprietary mutual funds and third-party funds. Because of such disclosures, the SEC pivoted to the theory that there should have been an additional disclosure that JPMS “preferred” to invest client assets in proprietary products.

Holding the bank to this level of scrutiny seems severe; as noted, JPMS disclosed its incentive to put client money into house funds and these were discretionary accounts. Its “preference” for house funds seems axiomatic. All things considered, however, the penalty could have been far worse. Perhaps because of its cooperation and proactive remedial measures, J.P. Morgan was permitted to continue to provide these kinds of investment advisory services and was able to avoid the so-called automatic “bad actor” disqualification, which would have blocked it from the lucrative business of raising money for private companies, including hedge funds and startups. In addition, while the penalties and disgorgement are certainly significant, they amount to roughly one month of JPMS’s operating profits.

The Broker Compensation Case

In the second settlement, JPMS agreed to pay $4 million to resolve charges that it falsely stated on its private banking website and in marketing materials that individual advisors were compensated based on the performance of client investments, not on commission.[2] As it turned out, advisor compensation was not tied to investment performance; it consisted of a salary plus a bonus determined by a number of factors, none of which were performance based. Although it appears that no investor was harmed, the SEC believed that sanctions were warranted: “JPMS misled customers into believing their brokers had skin in the game and were being compensated based upon the success of customer portfolios.”[3]

Bottom Line

Based upon recent developments, it is clear that the SEC intends to look under every rock to see if all conflicts of interest, regardless of their severity, have been disclosed. Accordingly, firms should take a close look at their business practices and make sure their Form ADVs, websites, marketing materials and other disclosure documents accurately reflect those business practices.

[1] http://www.sec.gov/litigation/admin/2015/33-9992.pdf. The $267 million consisted of penalties, disgorgement and interest.

[2] https://www.sec.gov/litigation/admin/2016/33-10001.pdf. JPMS neither admitted nor denied any wrongdoing.

[3] https://www.sec.gov/news/pressrelease/2016-1.html.

SEC Remote Tippee Cases Now Subject to Higher Newman Standard

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The heightened Newman requirements for remote tippee liability apply not only in criminal cases but also in civil cases brought by the SEC.  On April 6, 2015, in SEC v. Payton, Judge Rakoff of the Southern District of New York ruled that the principles set forth in the criminal case, U.S. v. Newman (2d Circuit), apply equally in civil cases brought by the SEC.  That means, among other things, that the SEC must prove that the original tipper received a significant personal benefit from the original tippee.

As Judge Rakoff pointed out, however, there is an important distinction between a remote tippee case brought by the DOJ and one brought by the SEC.  While the DOJ must prove the remote tippee actually knew of the of the personal benefit provided to the original tipper by the original tippee, the SEC can rely on the lower “recklessness” standard.  Recklessness includes conscious avoidance of learning whether there was a direct quid quo pro between the original tipper and tippee.  Thus, in a case where a remote tippee has enough circumstantial facts at hand to raise red flags but refuses to search out whether there is a quid quo pro between the original tipper and tippee, the remote tippee may be civilly liable.

By applying Newman to SEC cases, the Court made it clear that the Government will have to be careful in bringing remote tippee cases, whether they are civil or criminal.  That said, all other things being equal, the safer path for the Government will likely be to go the SEC/civil route.

Judge Rakoff’s decision can be found here.  http://www.scribd.com/doc/261139623/SEC-v-Payton-Rakoff-Opinion-April-6-2015